Strong Jobs Report Raises a Question: How Much Can the U.S. Economy Grow?

The job market is strengthening so impressively that it has some people scared: What happens when the U.S. economy runs out of headroom to grow?

Today the Bureau of Labor Statistics announced that employers added 288,000 jobs in June and that the unemployment rate fell to 6.1 percent, the lowest since the financial crisis month of September 2008. Both numbers were a surprise. Economists surveyed by Bloomberg had been forecasting job growth closer to 200,000 and a flat unemployment rate of 6.3 percent.

Economists worked fireworks metaphors into their write-ups, but JPMorgan Chase Chief U.S. Economist Michael Feroli went automotive, writing, “The job growth numbers appear to be firing on all cylinders.”

Ebullience over the jobs report helped send the Dow Jones industrial average above 17,000 for the first time. Traders in the bond market were less excited because strong job growth can raise inflation, the enemy of bonds. The yield on 10-year Treasuries ticked up a fraction to 2.66 percent from 2.63 percent by late morning.

In May, U.S. employment finally rose above its previous peak of December 2007. In the past month it continued to surge higher, as this chart shows:

The strongest job growth since the recession is indisputably good news. On top of the employment gains, average hourly earnings rose 0.2 percent in June and 2 percent over the past year. That’s a healthy development because it gives workers the money they need to spend, helping both them and the economy. “My own expectation is that as the labor market begins to tighten, we will see wage growth pick up some,” Federal Reserve Chair Janet Yellen told reporters last month. Yellen said believes there is still plenty of slack in the labor market and no risk of inflation, so there’s no rush to start tightening monetary conditions.

Even long-term joblessness, which has been a sore point in this expansion, is easing. The number of long-term unemployed fell to 3.1 million, and their share of all jobless fell to 32.8 percent, the lowest since June 2009. The share of working-age people in the labor force—i.e., the participation rate—stayed little changed at 62.8 percent.

But there’s a dark cloud inside every silver lining: To inflation-phobes, a rebound in wage growth is a warning sign of inflation ahead. The fear is that the deep 2007-09 recession knocked many people out of the labor force permanently, so there’s not as much slack in the job market as there appears to be. On top of that, the inflation-worriers say, a lack of investment in labor-saving machinery and software means that workers’ productivity isn’t growing much, putting further pressure on the labor market.

Some economists said a strong economy will force Yellen’s hand and moved up their expectations of how soon the Federal Open Market Committee would begin to raise the federal funds rate, the rate on overnight loans between banks that it controls. The Fed has been pointing toward sometime in 2016. But Rick Rieder, BlackRock’s chief investment officer for fundamental fixed income, said in an appearance today in an appearance on Bloomberg TV that the Fed could start hiking as soon as the first quarter of 2015.

“Although wages are far from spiraling out of control,” there is “a rising risk of accelerating wage inflation,” James Paulsen, chief investment strategist and economist at Wells Capital Management, wrote in an analysis today.

In a report released on Wednesday, Morgan Stanley (MS) economists wrote that “if data trends continue to suggest that … there isn’t a large remaining margin of slack in the economy … the Fed may face some difficult choices.”

“They’ve got a problem. They’ve got a communications problem,” Joseph LaVorgna, the chief U.S. economist of Deutsche Bank Securities, said in a post-release conference call with reporters, referring to Federal Reserve rate-setters. He noted that the unemployment rate, at 6.1 percent, is already down to where Fed forecasters thought it would be by the end of the year.

Of course, if the U.S. has a problem with a too-tight labor market, it’s still far better off than other advanced economies with lower birth rates and less immigration. A Boston Consulting Group study this week said the U.S. may even have surplus labor in the years ahead.